Demystifying Tax for Startups and ICOs

Start-Ups Choosing an Entity

One of the most important choices you make when starting a business is the type of business entity. The agreement for the entity will spell out such important matters as how profits are divided, what happens when someone leaves, how business decisions will be made, and how members can be removed.

Tax reform threatens to introduce massive changes in the tax considerations for startups and ICOs

Benefits of LLCs

As readers of my post on the top four advantages of an LLC will know, an LLC has many advantages. The most important include limited liability for the members, ease and flexibility for setting up and operating, and tax treatment.

By default, an LLC is a “pass-through” entity. That means that an LLC does not pay tax itself, but instead the income of an LLC “passes through” to the owners. The income is reported on a Form K-1 that the LLC sends to its members so they know how much tax to pay. When the LLC distributes cash or property, the distribution is tax-free.

LLCs can also give the buyer of a business a big tax benefit. That’s because the buyer can receive a step-up in the tax basis of the business, which reduces the buyer’s tax bill in the future. Sometimes, buyers will pay more in the purchase price for this tax benefit, so it also helps the seller!

Another benefit is that LLCs can make an election to be treated as a C-Corporation for tax purposes. This can be a powerful benefit when the owners of an LLC decide they want the business to be taxed as a corporation.

Benefits of Corporations

Why use a corporation? Sometimes, an outside investor will require the business to be a corporation. Other times, the business owners may be more familiar and comfortable using a corporation.

There are tax benefits in organizing a business as a corporation. Tax compliance is much simpler, because the shareholders only pay tax when they receive a dividend. Some investors, such as foreign investors or tax-exempt organizations, won’t invest in a business unless it is a corporation.

Shareholders also have a potential benefit: the Section 1202 capital gain exclusion. This benefit can be very powerful: it allows shareholders to exclude $10 million (or even more!) of gain on the sale of stock. But it’s very difficult to qualify. Among other requirements, you have to hold the stock for at least five years.

Initial Coin Offering

ICOs are a hot topic today. But the proceeds of an ICO are likely to be taxable income. It doesn’t matter if the business receives cash or “virtual currency” such as Bitcoin, Ether, EOS, or another type of token that is convertible into cash. If the business doesn’t take this potential tax liability into account, there could be a rude awakening when preparing the tax return.

The tax liability has driven some businesses to form foreign corporations or foreign foundations to raise funds in an ICO. The tax treatment of an ICO both for the foreign corporation and its U.S. owners is too complex to describe in this post, so be careful!

Tax Reform

Tax reform threatens to introduce massive changes in the tax considerations for startups and ICOs, including:

Lower corporate tax rate. A reduction in the corporate tax rate will make corporations more attractive.

Lower pass-through tax rate. Congress is proposing a reduction in the tax rate for pass-through businesses, but it doesn’t apply to all businesses. Will your business qualify?

International. The changes in international tax may erode or erase the tax advantages to using a foreign corporation for an ICO.

If Congress passes tax reform, I will post a new blog article summarizing some of the changes for start-ups and ICOs, so keep posted!